You’ve likely heard about the new Tax Cuts and Jobs Act (the “Act”) that the President signed into law on December 22, 2017, but might not know exactly what it means to you as a business owner, and with it comes a slew of questions, especially, “what does that mean for me?”.
One of the primary features of the Act is the much-publicized permanent reduction of the top marginal corporate tax rate from 34% to 21%. While the top marginal tax rates for individuals is also reduced, the reduction is only from 39.6% to 37%, which is nowhere near the corporate tax rate reduction. A lesser known provision of the Act added a new section 199A to the Internal Revenue Code to provide a deduction (referred to herein as the “QBI Deduction”) to non-corporate taxpayers, which is intended to give some equivalence to the corporate rate reduction, at least with respect to business income of the non-corporate taxpayers.
We have outlined below a brief summary of the general rules to determine your QBI Deduction and certain exceptions and limitations to the general rules. However, this is only a summary and the actual rules can be quite complex. If you need more specific guidance on the application of these rules to the QBI Deduction, or other aspects of the Act, please feel free to contact us and we can set up an appointment with our attorneys that monitor the Act and its developments.
Basic Rules
The rules to determine your QBI Deduction, if any, is much simpler if your taxable income, determined before the section 199A deduction (“Taxable Income Base”) is equal to or less than $157,500, or $315,000 for a married couple filing jointly, adjusted annually to reflect a cost-of-living adjustment (such amount, as adjusted, is referred to herein as the “Threshold Amount”). In this case your QBI Deduction is equal to 20% of your share of trade or business income (“Trade or Business Income”) from partnerships, including limited liability companies taxed as partnerships, or S-corporations (“Flow-Through Entities”) and/or trade or business income generated by sole proprietorships, or single member limited liability companies that are disregarded for federal income tax purposes, that you own and operate. Generally, Trade or Business Income will not include investment income or capital gains or losses. Further, such income does not include reasonable compensation or guaranteed payments paid to you from a Flow-Through Entity. The QBI Deduction computed pursuant to this paragraph is referred to herein as the “Threshold Deduction”.
So long as your Taxable Income Base is equal to or less than the Threshold Amount, your QBI Deduction can be computed as noted above and you do not need to read further (except for the short section below entitled “Overall Limitations”).
Rules Where the Taxable Income Base exceeds Certain Amounts
Determination of the QBI Deduction gets significantly more complex whenever your Taxable Income Base exceeds the Threshold Amount because between the Threshold Amount and an additional $50,000, or $100,000 in the case of a married couple filing jointly (the sum of such amounts is referred to herein as the “Cap”) the new law contains rules that phase out amounts that would otherwise qualify for the deduction. The two most important of these rules are summarized below. Both of them relate to an overriding theme in the statute that the deduction does not apply, or is at least limited, to the extent income consists of payment for services.
If your Taxable Income Base exceeds the Cap, the 20% deduction does not apply to all Trade or Business Income, but only to “Qualified Trade or Business Income”, which is basically Trade or Business Income from a “Qualified Business”. A Qualified Business is a trade or business not involving certain specified services[1]. Whenever your Taxable Income Base exceeds the Cap, your 20% deduction will only be applied to income from such Qualified Businesses.
Limitation Related to Certain Wages You Pay and Capital Investment.
Further, if your Taxable Income Base exceeds the Cap, the QBI Deduction for each Qualified Business is limited to the greater of (i) 50% of W-2 wages paid by the business; or (ii) the sum of (A) 25% of such W-2 wages plus 2.5% of the cost of certain property (“Qualified Property”) used in the business. There are numerous complexities related to this limitation, including the determination of the cost of the Qualified Property. Further, owners of sole proprietorships and partners in partnerships cannot receive W-2 wages, so unless wages are paid to others, this limitation may relate solely to the cost of such Qualified Property.
Phase-in of the Limitations.
As noted above, if your Taxable Income Base exceeds the Threshold Amount, but not the Cap, you would reduce the Threshold Deduction only by a pro-rata amount of the reductions.
Overall Limitations.
In addition to the limitations above, your QBI Deduction is limited to your Taxable Income Base reduced by your net capital gain for the taxable year. Further, it is worth noting that your QBI Deduction is not allowed in computing Adjusted Gross Income, but is allowed regardless of whether you itemize deductions and if you do itemize, it is allowed without regard to limits on itemized deductions. It is also worth noting that the QBI Deduction applies only to federal income taxes and not to other federal taxes, including employment taxes.
Other Special Rules.
In addition to the above rules used to compute the QBI Deduction, there are special rules that apply to the following:
- Qualified REIT Dividends;
- Qualified Cooperative Dividends;
- Qualified Publicly Traded Partnership Income;
- Certain agricultural or horticultural cooperatives;
- Trusts and Estates;
- Qualified Business Income from sources within the commonwealth of Puerto Rico; and
- Alternative Minimum Tax.
We will continue to monitor developments with respect to the Act, including anticipated Treasury Regulations. Included in our team of experts at RWR Legal, is our very own Doug Ledlie, a Corporate and Tax Counsel at RWR Legal where he uses his extensive legal experience and background to represent clients in corporate and tax matters. Mr. Ledlie not only has a JD, but also an LLM in Taxation from NYU and experience as a CPA. His legal practice spans several decades in which he has represented clients in general corporate matters and commercial transactions, including start-ups, mergers and acquisitions, financings, corporate restructurings, and tax matters. In addition, Mr. Ledlie has written several research books on the Texas Business Organizations Code and Texas Tax Code.
[1] Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. Trade or business involving the performance of engineering and architecture services are specifically excluded, therefore, trades or businesses involving such services will be Qualified Businesses.
